What you see is not what you get

By Megan McArdle

Like Will, I wished I had had more time to spend on the Big Con book club at TPM Cafe, but last week was busy, and this week continues so.

Like Will, I had problems with this passage:

From 1947 to 1973, the U.S. economy grew at a rate of nearly 4 percent a year — a massive boom, fueling growth in living standards across the board. During most of that period, from 1947 until 1964, the highest tax rate was 91 percent. For the rest of the time, it was still a hefty 70 percent. Yet the economy flourished anyway.

None of this is to say that those high tax rates caused the postwar boom. On the contrary, the economy probably expanded, despite, rather than because of those high rates. Almost no contemporary economist would endorse jacking up rates that high again. But the point is that, whatever the negative effect such high tax rates have, it’s relatively minor. [emphasis mine]

My response to this was: huh? Two things Chait either does not understand or takes pains to ignore: (1) the relevant counterfactual and (2) the compounding nature of economic growth. He concedes that these astronomical rates put a brake on growth — and for about a third of a century (i.e., the ‘47 -’73 boom plus the following downturn until the ‘8os cuts.) So what would the growth rate have been with much lower tax rates? I don’t know. Depends on how much lower, obviously. But, other things equal, higher. (Anyone know of a rigorous estimate?) And Chait agrees.

My problem is a little different, though: the effect was probably not that big. And the reason it wasn't that big, is not that marginal tax rates don't matter, but that almost no one paid those marginal tax rates.

In 1951, the year that rate was enacted, the 91% tax rate kicked in at $400,000 for a married couple filing jointly (Moreover, due to statutory adjustments, its effective limit was about 87%, but that's a quibble). In today's dollars, that's about $3.2 million. By 1963, it's last year, inflation had eroded it to perhaps $2.7 million. That's the kind of income that puts you somewhere over the line for the top 0.05% of households in the United States. In other words, we're discussing something under 50,000 tax returns.

Moreover, even those who had very large incomes didn't pay anything like a 91% effective marginal rate, because deductions were much easier to come by before the 1986 tax reform. That's how we got the AMT; people used to find it relatively easy to structure their income to evade tax. Too, corporations found ways to give income to their employees in tax-advantaged forms, such as lavish expense accounts. So that rate impacted very, very few people, most of whom, I grant, would probably have kept working anyway just because they liked being the president of GM. But Fortune 500 CEO's are not where we look for the meat of the action on the incentive effects of tax changes; we look, rather to occupations that are remunerative but not particularly glamorous, like owning a plumbing supply factory or being a proctologist. And those people did not come near being impacted by such high tax rates.

Today, on the other hand, our top rate kicks in at about $300,000 of household income--the salary of two law firm associates. I'm not asking you to feel sorry for them, as I certainly don't; but the vast majority of law-firm associates I know are actively looking for jobs that will require less work. Raising the tax on their extra income by ten percentage points might well make that decision much easier.

(Which is not to say that we shouldn't do it; only that comparing this situation to 1951 is a little loonie.)